MASTERCLASS: Liability Driven Investing - October 2019
October 7, 2019
Chris Dillon: Hello, welcome to the first of what will be a series of quarterly webcasts provided by the T. Rowe Price, The Multi-Asset Division. Today's presentation is titled Global Diversification in an Uncertain World, and I am pleased to have two members of the asset allocation team in the Multi-Asset Division of T. Rowe Price. First of all, Sebastien Page, thank you for joining today. 20 years investment experience, joining to T. Rowe Price in 2015. Experience at Pimco, leading a team, researching Multi-Asset solutions for institutional clients, managing director at State Street, and also an author in terms of awards, various white papers written in a financial analyst Journal, Journal of Portfolio Management. Great to have you here today.
Sebastien Page: Thank you.
Chris Dillon: Mr. Vaselkiv, Mark Vaselkiv, chief investment officer for the Fixed Income come at T. Rowe Price, but joining T. Rowe Price in 1988 as a credit analyst. So, you've seen security selection from the bottom up, taking the reins for our high yield investment efforts, leading them since 1996, so still in that role leading the high yield team, CIO, fixed income, a lot of perspective here. Great to have you here as well, Mark.
Mark Vaselkiv: Thank you, Chris.
Chris Dillon: And I didn't introduce myself. I'm Chris Dillon, a member of the Multi-Asset Team, and I'm a moderator day and great to be part of this conversation. So again, quarterly series of presentations. We will be rotating members of the asset allocation committee through here on a quarterly basis and let's get started.
Chris Dillon: And we move to slide two. It's just a simple outline of what we will be discussing today. There will be just a brief introduction or review for some of you who are familiar with Multi-Asset, but just an update on the Multi-Asset business at T. Rowe Price. We will then spend some time talking about Secular Risk. This is a term being very much covered financial press. Many firms like T. Rowe Price out talking about it. We will spend time on that. Many of these conversations are focused on equity, but this certainly, Secular Risk, applies to fixed income. It applies to Multi-Asset. We're going to spend some time talking about secular risk, and then we've got specific expertise here. We're going to talk about how fixed income markets are looking from Mark Vaselkiv's perspective, and then how all of those viewpoints rep into things that we're thinking about on the Multi-Asset side of T. Rowe Price. So much to cover here today.
Chris Dillon: Let's get started with our agenda. Again, just a quick uptake with T. Rowe Price's Multi-Asset business here on slide four, so as for those of you following along with the slides, you'll see 25 years plus experience for T. Rowe Price on the Multi-Asset side. You'll see over on the far right-hand side, along strong track record of delivering risk-adjusted performance in our Multi-Asset investment strategies that go back a long way as we just said, 285 plus billion in assets of our trillion dollars in assets, in assets under management at T. Rowe Price overall. And then a dedicated team of professionals that seems to be growing pretty quickly, Sebastien, in terms of growth in the business, so 60 plus dedicated professionals here on the Multi-Asset side. Very quickly on slide five, and we're going to come back to this slide because we're going to move by this pretty quickly, but I think we've got Sebastien Page here leading Multi-Asset that we'd be remiss not to get your thoughts in terms of what we're featuring in our portfolios at this moment in time, so we'll come back here.
Chris Dillon: But this is a grid. And for those of you plugged into the webcast today, this is available on a monthly basis and this is a framework for how we're thinking about the world. It gives our view on stocks versus bonds, whether we're overweight, underweight, it looks at different regions, and how we're invested. There's a strategic underpinning here based off of a 50 year plus asset allocation committee. That will be our neutral. Then we are getting inputs from our equity team, our fixed income team, and we're also getting viewpoints from the street. We're evaluating all of that on a monthly basis, and that will lead to a tactical overlay versus that strategic underpinning.
Chris Dillon: All of that is summarized on this grid here. We will come back to what's here on slide number five. We're going to spend a lot of time here on slide number six, but when I think of Multi-Asset, and myself being a member of the team and as I'm observing it as an investment professional who's at engaging with clients, I think of this slide and I think of the strategic underpinning of the approach on the left-hand side, where it's strategic portfolio design, complemented with a tactical overlay. At the end of the day, all of this is reinforced the security selection fundamentally driven by T. Rowe Price's fundamental global research effort, and then a risk management overlay. Sebastien and I know you'll be spending time on the risk management overlay. And just in terms of our monthly strategy meeting on the right-hand side, the center of it is the asset allocation committee, members of which come from the equity side of T. Rowe Price, Fixed-Income side of T. Rowe Price, and then dedicated Multi-Asset professionals balancing these different viewpoints that come into us on a monthly basis from our global investment platform.
Chris Dillon: Let's dive deeper into this presentation and discuss secular risk, the emergence of a new competitive force, technological advance, changing customer habit, and/or regulatory change that is structural and long-term that results in a slower top-line growth rate, margin compression, and/or multiple compression. This feels very equity. And we've got Mark here from Fixed-Income, and we got Sebastien from Multi-Asset. But this is not just an equity story. This is also a fixed income story here. And I think, Mark, you had some interesting perspective on this in terms of a different lens on fixed income against this backdrop.
Mark Vaselkiv: Absolutely. If you spend a lot of time walking the halls of our offices in Baltimore, London, and Hong Kong, you'll often hear a major theme of investing on the right side of change because over the last 15 years, we've seen the advent of major new technologies that have disrupted traditional industries. Examples would include retailing, transportation, publishing, consumer behavior in a lot of areas, energy utilities. And what we've seen is that some of these dominant new technologies have led to outstanding performance for the underlying stocks clearly names like Amazon, Google, Apple, Netflix, we hope Tesla someday, but we also have to recognize that for many value investors, and I would include high yield as a value-driven strategy, many companies find themselves on the wrong side of change. And we debate and we struggle with how to invest in those companies that are more value oriented.
Mark Vaselkiv: When you look at the performance of equity strategies over the past 10 years, growth has dominated value. And historically, value investors would say, "Well, we can wait for mean reversion because ultimately the playing fields will level out," but that may no longer be the case for many value companies. They may face long-term secular declines, existential crises, if you will. So, the key for fixed income investors like ourselves is to try to avoid many of those companies on the wrong side of change, but also to participate where we can in some of the disruptive forces in our world.
Mark Vaselkiv: I would use Netflix as an example. While that company is known as being a large-cap growth stock, many people don't know that Netflix typically borrows about $2 billion of long-term debt every year because they're spending about $10 billion to develop new content in the United States as well as in other parts of the world. So as Netflix has issued new 10 year and 15 years securities, we have had the opportunity to participate. Tesla would be a second example. Tesla is a fixed income credit in our portfolios. We like Uber as well, company that may be coming public soon. So even for credit investors like ourselves, it's very critical to try to begin to add significant allocation to the companies that are on the right side of change.
Chris Dillon: Having had a chance to work with you a little bit in December in a venue for our sales team, it struck me when the idea of electric, not the idea, or the phenomenon of electric vehicles came up and it's point of inflection doesn't have to be precise, but 2025 the year of, sounded like a year to think about. So, owning longer maturity internal combustion auto manufacturer beyond 2025.
Mark Vaselkiv: Chris, the firm has spent a lot of time discussing what we will see as an autonomous electric vehicle tipping point. And you hit the nail on the head by saying that could happen somewhere around 2025. That will have profound implications for traditional auto manufacturers, some of the incumbents in Europe and the United States, but it's very different for a fixed income investor. On the equity side, the valuation of a common stock is largely dependent on its ultimate terminal value. And I cannot make a case beyond 2025, what the terminal value of a company like Ford might be on the equity side. However, if I own a 2023 Ford Credit fixed income security, knowing my maturity is four to five years into the future, the terminal value of a bond is certain, assuming the company doesn't default, and we can actually participate on some of these disrupted credit situations because our investment horizon is shorter than a traditional equity investor who might look out 10, 15, or 20 years.
Chris Dillon: As I toggle between fixed income and equities, struggle for myself is remembering bad news on the equity side like Kraft Heinz, what stock is down 60% from a trailing one-year perspective, but that bad news means that the spread is going to increase. You're going to get extra yield if you're going to own that paper. And I think of vice versa, general mills gets thrown into that conversation. That's a stock that's actually up 27% year to date. So, something that you would want to be owning from a tactical perspective, maybe even a strategic perspective. But that good news for general mills brings the spread in. So, it's sort of counter-intuitive, and I've been reading the research notes on fixed income, so Kraft Heinz Opportunity, general mills, these are both triple B credits, so just it's just interesting to me that it works in reverse a bit here in fixed income.
Mark Vaselkiv: Absolutely. There are many issuers who are bad equity stories and probably good bond stories. Again, as fixed income investors, we get to choose our investment horizon. Some of those companies, I wouldn't lend money to them for 10, 15, or 30 years. Keep in mind in the investment grade world, there are a lot of 30-year bonds, so you're taking three decades of credit risk inherent in that security. Whereas in the high yield market, where I've spent the bulk of my career, majority of securities are from five to eight years. Sometimes they're even shorter. So again, we like the shorter duration characteristics of some of the below investment grade strategies and that gives us a little bit more flexibility to remain in some of these sectors that will ultimately face disruptive challenges.
Chris Dillon: This is probably something that's going to come up later, and I may save this for you, Sebastien, but I heard some phraseology risky, fixed income may look attractive versus risky equities, but why don't we leave that for viewpoints. But we were on slide nine. Let's move over to slide 10, and then we're going to get Sebastien, get you much more involved with this conversation. But I think just from the perspective, and we're on slide 10, and four different things to think about in terms of managing around secular risk from an equity perspective, and we're not going to get through this because the expertise here is different than the, the deep equity dive we've done here. But mark, we did talk about sustainable energy companies. This is utilities being part of investing around secular risks that will bring much more of a consideration around security selection.
Chris Dillon: Let's remind investors that since March of 2009 to September 20th, 2019 you had just had to own the index to get 19% annualized returns. We can thank the Fed for quantitative easing and just to see of liquidity pouring into markets. But since 2015 it's been quantitative tightening and this brings in the idea of if you combine quantitative tightening along with this secular risk concept, stocks, election's going matter, picking bonds is going to matter and then sectors are going to be impacted as well. But mark, I just thought it was interesting like a Sempra energy or a next era energy and a part of this conversation.
Mark Vaselkiv: Yeah, we see in the utility sector a win, win, win situation in that historically this has been considered a sleepy industry sector where valuations have been less expensive than some of growth industries. But now, with the advent of alternative energy, renewable energy alternatives, we can invest in companies like NextEra that are a combination of traditional regulated utility. Florida Power and Light, considered one of the best run regulated utilities in the states and another business side that's the leader in solar and wind and hydro energy. And so, it's an industry where we do not expect to see negative pressure from regulations or governments. Ultimately consumers like utilities moving more towards alternatives. It's a win from a political perspective and hopefully, all of those constituencies align in what has historically been a defensive industry to turn it into more of a growth strategy.
Chris Dillon: Interesting. So here on slide 10, I'm looking at the top header and it's a reference to sectors and if we're making the point that picking stocks matter, sector weights within indices and index composition are going to matter, things that we've been talking about in Multi-Asset. Sebastien, I'd be interested to get some of your perspectives here as think about index composition at this stage of the investment cycle.
Sebastien Page: It matters a lot because it changes over time, but in that context, one of the debates we have at every single asset allocation committee meeting, and Mark will know this, is should we overweight growth stocks relative to value. We talk about disruption and there are many more disruptors in the growth stock portfolios than in the value stock portfolios which are more likely to be disrupted. However, as you mentioned, growth stocks have had a fantastic 10-year run relative to value, so they look expensive. However, we're late in the cycle. So, who wants to own value when you're that late in the cycle? Who wants to be long cyclical when you're that late in the cycle and round and round, we go in the debate in Q4 of 2018, we saw an opportunity to lean into growth stocks. So, we're slightly overweight right now. We liked them from a secular perspective.
Sebastien Page: The way I think about the disruption question is one of our portfolio managers has had that great analogy where he said, "if you look at a company and you ask, is it secularly challenged or not?" And by the way, our CIO has said very precisely, 30.92% of the SNP 500 represents secularly challenged companies. How do you answer that question, whether that company is secularly challenged or not? One of our portfolio managers said, "Well, just think about the future. Project yourself in a star trek world and to ask yourself, Chris, do they still have that product or service there? Do they still have cable TV? Do they still have gasoline cars?" And you begin to think of the framework when you apply that framework to sectors within the value style or the growth style, you quickly find that the secular forces favor growth stocks.
Chris Dillon: Interesting. And I think when we get back to that framework, we'll see that tilt towards growth and maybe revisit part of that conversation. And we're going to wrap up here on the secular risk side, but before we do, repeating the same thing, things that you just said, but often in my travels meeting with various clients, I hear the argument for value from a mean reversion standpoint. It's been growth over value for a decade and of course, because it's run for a decade, value is going to have its day in the sun. I think from our perspective and interested to get your take here, that's not a good enough argument.
Sebastien Page: Yes, and I should clarify, we have a secular long-term bias towards growth stocks, but our portfolio is also allocate to value stocks in our portfolio managers in the value space find companies that they like that aren't secularly challenged. So, there is balance in our portfolios despite that bias. And if you zoom out, Chris, instead of looking at the last 10 years, if you say, "I'm going to go back to 1930," okay, the world was very different back then and I always hesitate to use that long range of data. But nonetheless, before this 10-year period post-crisis, which has been a low growth environment, and therefore, has favored cyclical growth stocks, value outperform for that 80-year stretched. So perhaps there's maybe not an 80 year stretch for growth, but if you put that in the context of secular challenges and disruption, perhaps there's more room to grow for growth stocks in the US. We can talk about growth stocks outside the US as well, but you have to always put it in the context of valuation, short terms as well as long-term perspective.
Mark Vaselkiv: And Chris, we may be saying that ultimately value-driven fixed income strategies like emerging markets debt and high yield might make more sense in the future and value-driven equity strategies. Getting back to this idea of mean reversion. In mean reversion and fixed income, that means maturity part. Getting your money back. Mean reversion inequities in a secularly challenged company is much more problematic.
Sebastien Page: Mark makes a very good point here, and we've had that conversation several times. Fixed income markets mean revert more than equity markets. All else being equal. If your time horizon is say six to 18 months, the starting valuation for Fixed Income Markets, the spreads, and the yield levels are more predictive of forward 12 month returns than pes for stocks, for example. So, when we look at relative value between stocks and bonds and within fixed income sectors, one of the key signals is the relative yields and spreads between those sectors.
Mark Vaselkiv: How about this first statistic, Chris? The high yield market in its entire 40-year history has never lost money two years in a row. That's the ultimate in mean reversion. More importantly than that, some of the best years in the history of the high yield market have come right after a year of negative performance. It happened after the financial crisis. It happened in 2016, how you market lost money in 2018, and it's off to a strong start again, the first quarter of '19. To us, that makes for a sustainable long-term fixed income strategy.
Chris Dillon: Slide 13, or just three points around secular risk. It's growing from our perspective, number of attractive industries, companies shrinking, navigating secular, crucial to investing success in fixed income, in Multi-Asset, inequities, to wrap up that secular risk portion of our presentation. But there's a lot going on in fixed income. It's been performing well. You're saying risky, fixed income better. You just touched on emerging market debt and high yield and it's an interesting slide here on slide 15, Mark, taking the world fixed income markets, interest rates sensitivity across the horizontal bottom access yield to maturity across the left vertical access, and then we've got those bubbles, let's not forget that. And we're thinking about this and multitask at all the time. That's the correlation back to the Equity Side of the ledger. So, some thoughts from you here, Mark.
Mark Vaselkiv: Chris, what a difference, a couple of fed meetings can make. Think back to the fourth quarter of 2018. Perceptions over tighter central bank policy, particularly from Mr. Powell and his colleagues. Slowing economies globally, Europe and China, Pete corporate earnings potentially in the United States, and then almost a 180-degree pivot at the end of the year and now into the first quarter of 2019. I would say that the investment climate has gone from the polar vortex to 72 and sunny, and it's been pretty amazing recovery and in the first three months of 2019 with that fed pivot, literally almost all fixed income strategies have performed very well, especially a recovery in the plus sectors like emerging market debt, as well as high yield and bank loans. And sadly, many clients sold a lot of their positions in these strategies in the fourth quarter because they did not perceive that pivot from the Fed. They thought it was quantitative tightening, and more of that menu for the remainder of this year.
Mark Vaselkiv: And so don't fight the Fed when we have quantitative easing, certainly you don't want to fight the Fed during QT or quantitative tightening. Well, that quantitative tightening lasted less than a year. And what kind of back to QE, and we think we have some positive runway in some of these plus sectors as well. Let's not forget that interest rates have fallen sharply, particularly in March of this year. Treasuries, 10-year treasuries have come back down about 2.4. Everybody's worried about a flat yield curve, but the reality is absolute level of rates in the United States are currently low enough to help sustain this economic recovery in this cycle. Probably through the end of this year to at least into 2020 so a lot of favorable tailwinds for fixed income. Everybody's talking about what a great quarter it was for equities Q1. Well, fixed income delivered some pretty outstanding results as well.
Chris Dillon: You talked about the Fed, and I think we should give some credit to our fixed income colleagues cause yields were rising in early September 2018. And I travel a fair amount in my line of work and I'm on panel discussions with other firms that will remain nameless for the purpose of this webcast, but there were certain high-level firms that we're seeing. The Fed was going to go 25 basis points in December, and we're going to go four times 25 basis points in 2019, not a good prescription for fixed income, not a good prescription for equities either.
Mark Vaselkiv: Or the economy.
Chris Dillon: Or just everything out of the window so to speak. All of the above. But I think give our fixed income colleagues credit where they were leaning against that thought process. And I think if that, and I think a Multi-Asset where we started wading into emerging market debt, I'm going to say August, September of last year on the hard currency side, the dollar-denominated then until the local than emerging market equity, was there progression? But I think we differentiated ourselves with that, with that call, and it ties in.
Sebastien Page: Chris, I was having a discussion with a colleague from the asset allocation committee when markets were selling off, and we were talking about what you're talking at the moment, this view that rates could continue to rise despite softening economic data. And my colleague, he shall remain nameless, but I'm going to say he's on this panel, and his last name rhymes with El Kev. He looks at me from his 35 years of experience investing phenomenal track record as an investor. And he said something to me that has stuck with me and that speaks to the current investing environment. He said, "Sebastien, every time the Feds slams the breaks, someone's head goes through the windshield." That was the sentiment around Q4. You can't underestimate this Fed pivot, and the effect it has had, and the effect it will have.
Chris Dillon: And a 20% bounce plus in the S&P 500 since Christmas Eve in terms of the power of the Fed, and also applying to plus sectors on the fixed income side. Mark, we've got a couple other slides in your section here that are topical. One is, if we've had a good run in risky fixed income spreads, how do we look?
Mark Vaselkiv: Spreads actually have improved a little bit since the beginning of the year, January and February, a lot of tightening, but with rates falling in March, spreads in high yield, widened a little bit for 50 over may not be the most compelling spreads. But remember, that translates to about a six to six and a half percent carry today, relative to Treasuries at two to two and a half percent. So, 6% and a low-interest rate environment in the context of the United States looks good. It looks even better globally when you think of the fact that something like $11 trillion of fixed-income securities around the world still carry negative yields. We're back to negative yields on German bonds all the way out to nine years in maturity. And that makes the case for higher income strategies in emerging as well as high yield on a relative basis somewhat compelling today.
Chris Dillon: One of our global equity portfolio managers running a global equity portfolio talks about the guard rails around inflation. That being demographics and technology, part of that secular risk story. You've got technological advancement, inflation, not an issue. You do have some, signs of wage pressure, but inflation, not an issue. I think it sort of feeds into comments you were just making.
Mark Vaselkiv: Well, getting back to this idea of disruptive technology and secular change, a significant impact from many of these companies has been to reduce the overall level of inflation in the economy. It's keeping wages down. And that trend will probably continue on into the future. Thinking about autonomous driving for example, and what that will mean for people today who move their products by rail or truck. Truck drivers may go away. You look at it in areas like, energy where horizontal drilling has uncovered and unlocked substantially new stores of oil and gas reserves keeping the cost of energy relatively low. So, it's happening over and over again. And with inflation largely at bay today, I think that makes another case for lower interest rates for longer, and it preserves the economic cycle for a little bit into the future.
Chris Dillon: It's the fixed income section. But Sebastien, we made a move and Multi-Asset, September 2017. We went a lot more global. And I think there's going to be perspective from both of you here about cycles. I don't know, some thoughts in terms of the move we made. It was a lot less Bloomberg, Barclay's Ag and then some global dynamic, absolute return, fixed income, some international hedged fixed income. Those were moves that we made. It was a substantial move, I thought, from our perspective.
Sebastien Page: We like international hedged bonds at the moment, and we've been adding to the asset class. The interest rate differential, some of the things Mark is talking about with zero or negative yielding rates outside the US, and then rates at say 2.5% in the US. That differential makes the hedging interesting. It makes the hedging back to US dollar a positive carry. You earn excess return on that. If you look at our international bond hedge portfolio actively managed, at the moment in yields about 4.2%. Compare that to 3.2 for the Barclays Aggregate. That spread is quite interesting. It's in the top 90th percentile of the last 15 years, so we see an opportunity to lean against those valuations playing mean reversion in what you could call relatively safe carry because you get extra carry, but it's US dollar carry.
Chris Dillon: And some diversification of monetary policy cycle as well as economic cycle, Mark?
Mark Vaselkiv: Absolutely. When you look at this current slide here, that highlights the four different phases of a credit cycle, and I think you can also apply this to an economic cycle or even an interest rate cycle. It's been proven that investing in the repair, and the recovery phases at attractive valuations typically leads to much better outcome in terms of overall investment performance. So, let's use China as an example today. Clearly, a country that's faced some challenges as their growth has slowed dramatically in the last year, but now some positive stimulus is beginning to gain traction and the economy is showing some green shoots, signs of life again, and people feel a lot better about the second largest economy in the world. Obviously, that has significant spillover effects for other regions, not just around Asia, might actually help Europe because Europe is a significant exporting boarding region of the world. So, will this give a little bit of a tailwind for Europe to get back on its feet?
Mark Vaselkiv: Conversely, if you're over weighted region or a country like the US, that might be on the inflection point between expansion in downturn, there's significant risk there. We would, for example, be very concerned about a country like Mexico because of its close correlation and tie to the US economy. If the US economy where to catch the flu, then the Mexicans would probably catch pneumonia. It's an old adage, but it's true. So, where you invest along the credit in the economic cycle really can affect your long-term investment performance. So, given the fact that we might be very late in the US today, and that's an important assumption, you might want to now engage in broader diversification globally in the event that that transpires in the next year or two.
Sebastien Page: May I just had Chris, we sound like we're cheering for fixed income a lot so far, and I want to clarify that stocks are a crucial part of investor's portfolios from a strategic perspective. And if you take a longer time horizon and you're saving for retirement, it is the engine of growth in investor's portfolios. Ultimately, we ended up currently tactically roughly neutral between stocks and bonds. It's not the most exciting position. You're kind of waiting for opportunities to move in one direction or the other. But let's not forget the role of stocks. Stocks are awesome. I say that often. Stocks are awesome.
Chris Dillon: It's a huge point, and we are neutral between stocks and bonds right now, which to your point, 60% of your portfolio of global equities at lot to think about. You mentioned ...
Mark Vaselkiv: Could I make one more editorial?
Chris Dillon: Sure. I think we can get flexibility here.
Mark Vaselkiv: One of the most important lessons I've learned in my 30 years at T. Rowe came from our former CIO, Brian Rogers, who said that a lot of investors engage in destructive inconsistency. And this slide is a perfect example ...
Chris Dillon: Slide 19.
Mark Vaselkiv: ... Of that. What you have here, a lot of short term market timers, investors who panicked in the fourth quarter of 2018 sold their positions in high yield, and bank loans and as a result missed a tremendous rally in the early part of 2019 forgot about the fact that it's a resilient asset class, mean reversion always works in your favor after a year of negative performance. Again, to us, this speaks of the importance of taking a long-term structural position allocation in these plus sectors in fixed income rather than trying to navigate tactically. Credit markets timing, fixed income is very challenging even for the most sophisticated institutional clients.
Chris Dillon: And we're going to get to it with market viewpoints, but interesting in Multi-Asset we were underweight equity Beta off of our 60/40 and it looked bad on Christmas Eve. But to Mark's point with that strategic underpinning. And thinking of a US recession, not at the beginning of 2020 potentially farther back, we absolutely leaned in and as you said, we're neutral stocks and bonds. Getting part of that balance that's occurred from the year to date, or the time period since Christmas Eve. Let's go ahead and transition over to Multi-Asset. And Sebastien, I don't want to steal a punchline for your section of the presentation here, but I heard Mark say late cycle. And I wasn't counting, but I heard it at least twice. And a portfolio can look diversified when the sun is out, and it can be behaving differently when the sun is not out. And I've seen presentation on your thoughts from that perspective. But it'd be great to get your viewpoints here from a Multi-Asset standpoint in an uncertain world.
Sebastien Page: So if you look at what we do in Multi-Asset, ultimately, we package all of the firm's capabilities into one vehicle. And that includes tactical asset allocation, the discussions we're having. It includes risk overlays, it includes the security selection in actively managed building blocks. It also includes a lot of thinking around strategic asset allocation. One of the key questions for strategic asset allocation is how you diversify a portfolio. Let's think about it tactically first. When you're late in the cycle, and you have a PE ratio on US stocks of say 17 where we are right now. Does it mean the same thing as when you're early in the cycle? It doesn't. Early in the cycle, a PE ratio of 17 on stocks has a very different distribution of forward 12 months returns.
Sebastien Page: You go back in history, and you look at when valuations were in that range, you look forward 12 months. If you're early in the cycle, the average returns around 17% and most of the outcomes historically had been positive for stocks. Take the same valuation range and position yourself late in the cycle, but then look 12 month forwards historically, you get a very different picture. The average return is five or 6% and you get much more exposure to large losses. So, the risks are different. And what happens when you get those large losses? Often diversification will leave you. And that is exactly when you need diversification. The unfortunate thing, Chris, I've been working on this for years from a strategic asset allocation research perspective is that diversification, it works quite well when you don't need it. When markets go well, you get good diversification and we all know this and by intuition that when you get a negative outcome, which are more likely when you're late in the cycle, asset classes start to move together. Credit starts to move with equities and other risk-on strategies all fall together.
Sebastien Page: I started researching this before the global financial crisis. We looked at a bunch of asset classes, and we simply parse the data between down markets and up markets, and we published a paper in the Journal of Portfolio Management titled, very aggressive title, The Myth of Diversification that showed this asymmetry between downside correlations being so high on the downside, and so low on the upside, even negative on the upside. This was before the crisis. And we were using pre-crisis data. It was interesting in the crisis to see that occur more than ever before even commodities went down with everything else. And the paper was published right after the crisis because you get a lag when you publish these papers. It won an award. I don't think the paper was particularly good. I think it was a combination of the title, The Myth of Diversification, and the timing post-crisis.
Sebastien Page: Well, recently, I asked my colleague Rob Pan Relo to look at the question again with a broader set of asset classes and with 10 more years of data, nothing really new for investors, but how bad is this problem between downside and upside correlation differences or diversification differences? It's very pervasive. It's persistent, so our new paper, which is out in the financial analyst's journal, this title, When Diversification Fails. It's not as broad or strongest statement as the Myth of Diversification. We do believe in robust diversification that focuses on the downside events, but it makes the case quite clearly. We can look at a slide ...
Chris Dillon: Let's do that.
Sebastien Page: ... That shows correlations between pairs of asset classes in two very different environments.
Chris Dillon: Slide 23.
Sebastien Page: In the first environment on the left, we're looking at correlations when equity markets are in their bottom 5%. And the correlations on the right, we're looking at the same measures, how do these asset classes diversify each other, but when equity markets are rallying in their top 5%, look at the difference. Investors know this. It's intuitive, but investors might not know the extent to which this problem applies to different pairs of asset classes. Take US and non-US stocks. When us stocks are rallying, the correlation between US and non-US stocks is minus 16%. You can spot it there on the right.
Chris Dillon: I see it.
Sebastien Page: What happens to that correlation when US stocks are in their bottom 5%? It goes up to 87% the point I want to make here on strategic portfolio diversification is that investors must avoid using averages. The average correlation between asset classes, which is often used by advisors and investors to optimize or diversify portfolios is meaningless. It's worse than meaningless. It's dangerous. It's kind of like saying, "I have my head in the freezer, my feet in the oven, but my average body temperature is awesome. Perfect. I'm very comfortable." You're suboptimal if you diversify using average diversification properties in down markets and you're also suboptimal in up markets because quite frankly, we don't want diversification in up markets. These problems become more pronounced when you're late in the cycle because the risks that you shift to the left as we've seen in Q418 increase.
Sebastien Page: So, Chris, in slide 24, if risk asset classes don't diversify each other in times of extreme market stress, how do we construct robust diversification into our portfolios? The diversification of last resort, if you will, is going to be the risk on risk off diversification between stocks and treasuries. Here's a correlation profile. The bottom axis shows the percentiles in US stock returns. So, if you go all the way to the left where it shows zero, those would be the worst selloffs in stock returns they're around minus 40% as you move to the right, you go all the way to more positive and more positive outcomes all the way to the best strongest stock rallies of 20, 30 plus percent. That profile, unlike the ones we just saw, is a desirable diversification profile because the correlation goes way down when stocks sell off on the left and it goes up when they do well on the right, so the stock-bond correlation becomes a key component of your portfolio diversification decision. The problem with it is that it's actually hard to model itself. If you go back 80 years and you look at the 12-month stock-bond correlation over time it shifts sign from positive to negative 29 times. It ranges between minus 80% and plus 80%.
Sebastien Page: It is hard to model and predict the stock-bond correlation, although it isn't an important part of how you diversify your portfolio. You also see, if you plot the 12-month stock-bond correlation over time that we tend to go through regimes, periods of time during which it is mainly positive, and periods of time during which it is mainly negative. And we've been in a mainly negative stock-bond correlation regime. The question is what explains those regimes? If you're looking to calibrate, diversify a portfolio to a certain risk level, and you're assuming in negative stock-bond correlation. If you're assuming that stocks and bonds will diversify each other, what happens if they actually don't, and you get a taper tantrum type environment and both asset classes go down? You've underestimated your risk. We found that what drives positive stock-bond correlations are shocks and interest rates and shocks and inflation. What drives a negative stock-bond correlation are shocks to the business cycle, risk on, risk off, flight to safety effects. All these considerations argue for thoughtful portfolio construction that accounts for [inaudible 00:44:44].
Sebastien Page: Now, with Chris, we've left the realm of tactical asset allocation. We're talking about how you structure a portfolio for the long run, what we call strategic asset allocation, but those questions matter. What are the solutions? How do you address this? Stock bond diversification remains crucial, but you can also begin to look at more absolute return-oriented strategies or more dynamic strategies when you can change your risk level over time to stabilize your volatility. And by stabilizing your risk over time, by being more dynamic, you can protect your portfolio in times of stress. So, the takeaway I want to give on this is that there are investment methodologies and solutions that can be applied to build better diversified strategic asset allocations. It is of most importance when you're that late in the cycle and your equity Taylorist increases.
Chris Dillon: Great perspective in terms of the move we made, September 2017 a lot less Bloomberg, Barclays. Absolute return fixed income international hedge which we talked about. I also think we still use long treasuries as part of this dynamic. The tactical overlay relative to what could be changing dynamics late in the cycle. All of this comes into play. That's an ending perspective.
Sebastien Page: Chris, you like to talk about the moves we get right. We rarely talked about the moves we get wrong. We don't get all of them right. The good news is that we get more right than we get wrong, just to clarify.
Chris Dillon: A hall of fame economist is right 51% of the time. I think we do a little better than that. Slide 25 and there's any additional considerations you wanted to highlight here in all Sebastien?
Sebastien Page: Just be aware of averages and be very thoughtful on how you diversify your portfolio. Focus on times of stress. What would the portfolio have looked like if we entered stressful markets? Bring scenario analysis from a back-office function to a front office function, where it drives your portfolio allocation decisions. I'm not arguing for everyone to de-risked their portfolios. I'm arguing for the risk models to be more focused on exposure to loss as opposed to volatility or average correlations or sharp ratios.
Chris Dillon: We have you here, you're leading our Multi-Asset investment efforts. We're coming up on time and we talked about revisiting that frameworks slide, as I'm scrolling through here. It's going to take me a bit to scroll to it, so why don't we just speak to our viewpoints. Neutral between stocks and bonds and I'm going to stop there and I'm going to let you talk about how we're positioned in our Multi-Asset strategies right now
Sebastien Page: Playing offense in some areas. We had been overweight small-cap stocks. We have taken in profits to a certain extent in those positions, but we're still overweight. We like emerging markets, equities. Overall non-US equities have been a challenge for us because they've been so cheap, so extremely cheap relative to the US from a long-term valuation perspective, but also challenged, especially from the perspective of financials in Europe and structural issues. So, we've actually been taking some money back from international value in particular, which we've added to high yield. I'm talking about recent changes on the margin. If you look at those charts, you see a dot in front of every asset class. If the dot points to the right, it means we're overweight on that side. If it points to the left, it means we're overweight on that side. And then in the middle means neutral.
Chris Dillon: And I always think of our international equity positioning and I think if we're spending 100 cents, 70 those cents are US equities, 30 of those cents are international equities. And we have stayed the course and I think our 30 cents on the dollar international equities is underway relative to many peers but does provide diversification, cheaper valuation. Investors on the international side were disappointed last year with a strong dollar environment. We're talking about, we haven't specifically said it, but it doesn't look like the Fed's moving this year and it also looks like a pause from the balance sheet perspective. If there were expectations around the Fed 4 times, 25 basis points, that seems to take significant error out of the idea of a strong dollar. So, staying the course on international equities, emerging market equities, it could be a better runway here.
Sebastien Page: You make a good point Chris. We have to think of emerging market equities separately. They are cheap by historical standards. Just the last 12 months, the MSEI emerging markets is down 15% relative to the US stock market. So, there is some value there if you get a meaningful trade deal. The issue is that a lot of the trade deal enthusiasm as somewhat been priced in and you have different layers of this, easy or relatively easy, hard and very hard. Relatively easy, the US comes to an agreement with China to sell more US products to China. Hard, agreement on IP, intellectual property, protection in the whole technology area. Extremely hard, enforcement of that agreement. So, the whole trade situation influences the view on emerging markets. But when you look on balance at a more dovish Fed, potentially weaker US dollar, attractive valuations starting point where EM has underperformed, US stabilizing global growth, pretty good PMI print in China in February, you see an opportunity to overweight that asset class, perhaps more than European value stocks.
Chris Dillon: It's potentially muddling along here, neutral between stocks and bonds. Before we leave here, Mark, any final thoughts from your perspective?
Mark Vaselkiv: I would just highlight that in the emerging world there is great opportunity to add value through active management because clearly, China is a major story in EM. Most of the world focuses on developments there, but there are plenty of other countries where we have fascinating reforms beginning to take place in countries that were historically very challenged. Brazil would be a great illustration today, South Africa, these are areas where our research analysts and our portfolio managers working around the globe can find opportunities for significant absolute performance. So, this whole notion of casting a wider net both in fixed income as well as inequities, not easy to execute, but firms with the deep resources like we have. The boots on the ground all over the world, I think that gives us a formidable edge competitively to take advantage of those potentials.
Sebastien Page:Chris, if I can add.
Mark Vaselkiv: Please.
Sebastien Page: We've had 20 trillion in liquidity injections roughly by central banks globally since the global financial crisis. Investors are worried about where we are in the current environment and the dovish fed position is helping, but there's a tremendous amount of uncertainty and it's going to be a tough environment to invest. Security selection, in my opinion, is going to matter a lot. Sector Selection, dynamic valuation, driven asset allocation is going to help but it's not going to be easy. And to advisers discussing these situations with clients and their portfolios. I would say something that my mentor told me years ago and I'll always remember it, he told me that the secret to happiness in life is to lower your expectations. And that I think is a good way to summarize the current investing environment, to end on a positive note out.
Chris Dillon: I want to thank you both for the time we spent today. Sebastien, thank you for your perspective. Mark, great perspective on Fixed-Income. And with that, that concludes our webcast today, Diversification in an Uncertain World. And before we leave you, there's a continuing education credits for tuning in to the webcast today. There's additional continuing education credits for the white paper that Sebastien mentioned along the way titled, When Diversification Fails in The Financial Analyst Journal, go ahead and do a Google search out for that. And if you read it, there is additional CE credit for consuming that white paper. A lot of work went into that. So, thank you for that content as well, Sebastien. Thank you most so much for joining. Look forward to seeing you on our next quarterly webcast.